The Financial Conduct Authority (FCA) has finalised its rules relating to a new authorised fund, the “Long-Term Asset Fund” or LTAF. The purpose of the LTAF is to provide a UK authorised open-ended fund structure that enables investment in long-term, illiquid assets, including venture capital, private equity, private debt, real estate, and infrastructure, while offering appropriate structural safeguards. It is envisaged that investment in such funds will support economic growth and the transition to a low-carbon economy.
The FCA first consulted on draft rules for the LTAF in its Consultation Paper 21/12 (CP21/12), with rules for the LTAF initially published in the FCA’s October Policy Statement PS21/14 (PS21/14). The FCA published a further Consultation Paper CP22/14 (CP22/14), which proposed changes to the initial LTAF rules and, in particular, to broaden retail access to the LTAF. The FCA published a final Policy Statement PS23/7 in June 2023, making the rules final and further consulting on whether excluding Financial Services Compensation Scheme (FSCS) cover for the LTAF would be appropriate in circumstances where investors are taking an informed risk. The FCA is currently considering FSCS compensation more widely in its Compensation Framework Review.
The LTAF is the culmination of considerable work undertaken by the industry, regulators and government, including the Investment Association (IA), which published its UK Funds Regime Working Group report in June 2019 and put forward proposals for an LTAF as further developed in the IA’s LTAF position paper (July 2020). The FCA worked with the IA and other stakeholders (including the Productive Finance Working Group) on developing the LTAF proposals, as contained in PS21/14. The FCA consultation CP22/14 on broadening retail access followed on from industry feedback and an earlier commitment from the FCA to consider a wider investment base.
Why create an FCA authorised fund type for long-term, illiquid assets?
In CP21/12 and PS21/14, the FCA set out the rationale behind the LTAF. The FCA noted that long-term, illiquid assets can provide a useful alternative investment opportunity for investors with long-term investment horizons who understand and are able to bear the risks associated with such assets.
Traditionally, UK investors have invested in long-term assets via closed-ended structures such as limited partnerships, venture capital trusts and investment trusts. Having an FCA authorised fund which invests in long-term assets should broaden choice to investors by widening the options available, as well as helping the UK compete globally.
Open-ended funds that invest in illiquid underlying assets but permit daily dealing without notice can create a liquidity mismatch, which is hard for fund managers to deal with and potentially brings wider systemic risks. The FCA therefore decided that there must be consistency between the notice required from investors to redeem and how long it will realistically take the LTAF to sell its assets. The FCA rules require at least a 90-day notice period for redemptions (discussed further below).
An important potential market for the LTAF is the defined contribution (DC) pension market, and the rules integrate the LTAF into the regulatory framework for the investment by DC pension schemes in unit-linked long-term insurance products, via amendments to the “permitted links” rules. The LTAF will also be available to other professional investors, sophisticated investors and certified high net worth individual investors. Other retail investors, subject to certain controls (discussed further below) are now also able to invest in the LTAF.
What is the LTAF?
As set out above, the LTAF is a new type of open-ended FCA authorised investment fund, the purpose of which must be to invest mainly in assets which are long-term and illiquid in nature.
The LTAF is an open-ended fund. However, with a minimum notice period of 90 days to redeem and dealing not allowed more frequently than monthly (plus other permitted liquidity tools), the LTAF looks quite different to other types of FCA authorised funds.
The basis of the LTAF regime the FCA proposed in CP21/12, was strong governance and clear disclosure. The FCA has maintained this approach in the rules set out in PS21/14.
The specific rules for the LTAF are contained in Chapter 15 of COLL. These rules are principles based to provide the framework for the LTAF and allow a high level of investment flexibility. Taking account of the nature of the assets which the LTAF will hold, there are certain additional requirements particularly on the manager and depositary. The LTAF will be an alternative investment fund (AIF) and hence FUND will apply, in addition to other rules derived from the alternative investment fund managers directive (AIFMD) as implemented in the UK which are specifically referenced in COLL, Chapter 15). Other rules, including those set out in the COBS, PRIN and SYSC sourcebooks, will also apply.
Which FCA authorised fund structures can be used?
The LTAF can be established as a unit trust, open ended investment company (OEIC) or authorised contractual scheme (ACS).
The initial LTAF rules categorised the LTAF as a non-mainstream pooled investment (NMPI) which meant that for distribution purposes, it would have the same status as an unregulated fund. As a result of feedback, the FCA made further changes to re-categorise a unit in an LTAF as restricted mass market investment (RMMI), in line with the FCA new financial promotion rules as set out in Policy Statement 22/10 (PS22/10). The rationale for this is that the LTAF is subject to more stringent governance and diversification requirements than a typical NMPI, such as an unregulated fund. Classifying the LTAF as an RMMI means that LTAFs can be marketed to retail investors, albeit certain rules and controls must be followed, including risk warnings (see below). If a retail client is not advised, then the appropriateness test will also apply.
The rules specifically note that a Charity Authorised Investment Fund (CAIF) can be structured as an LTAF. Certain other regimes, including the Property Authorised Investment Fund (PAIF), and Tax Elected Fund (TEF) regimes, are also available for the LTAF.
What are the investment and borrowing powers of the LTAF?
The investment and borrowing powers of the LTAF are based on the existing rules for the qualified investor scheme (QIS), but with certain differences mentioned below.
The FCA rules for the LTAF provide that its investment strategy must be to invest mainly in assets which are long-term and illiquid in nature, or in other funds which invest in such assets. FCA guidance in relation to this high-level permissive rule is that the FCA would expect the strategy of the LTAF to be invest at least 50 per cent of its assets in unlisted securities and other long-term assets, such as interests in immovables or other funds investing in such assets. The guidance confirms that an LTAF could have a strategy of investing mainly in a mix of unlisted assets and listed but illiquid assets.
The manager of the LTAF will need to ensure that, taking account of the investment objectives, policy and strategy, the scheme property of the LTAF aims to provide a “prudent spread of risk”. This requirement matches the standard expected of a UCITS or NURS, but is different to that of a QIS, which is only required to have a spread of risk.
Chapter 15 of COLL sets out permitted investments for the LTAF, which include specified investments, immovable assets and commodities, loans (subject to certain conditions), as well as collective investment schemes (CIS).
CIS investments may form an important part of LTAF assets. The rules permit investment in both regulated and unregulated CIS, including limited partnerships. There is no requirement to ensure the underlying CIS does not invest more than 15 per cent in CIS, which is welcome, and would therefore allow investment in funds of funds. There is, however, a principles-based approach requiring that the manager is comfortable that the LTAF does not then invest back into itself. There are also rules relating to due diligence both initially and ongoing, where the LTAF invests more than 20 per cent of the scheme property in unregulated CIS, QIS or other LTAFs.
The FCA has confirmed that investment in intermediate holding vehicles, whether or not the vehicle is overseas, is permitted.
Borrowing is permitted up to 30 per cent of the net asset value of the LTAF, which is less than the 100 per cent allowed for QIS. There are no rules on aggregate borrowing of underlying investments.
What are the rules on dealing and redemptions?
Given the nature of the LTAF assets, the FCA has decided that the LTAF can redeem units no more often than monthly: daily dealing is not permitted. In addition, the rules require the LTAF to have a minimum notice period for redemptions of at least 90 days. In practice, the FCA expects that many LTAFs will have significantly longer notice periods.
The period between dealing days will depend on the reasonable expectations of the target investor base and the objectives and policy of the LTAF.
In addition, the rules allow managers to use a range of liquidity management tools appropriate to investment in illiquid assets, if they are disclosed clearly to investors.
Permitted liquidity management tools
|Any liquidity management tools must be clearly disclosed in the prospectus (including worked examples of what they mean for investors in practice).|
The FCA is clear that an LTAF should not expect to use (nor rely on) suspension as a means of managing fund liquidity in the normal course of events. The FCA also expects the manager to be able to manage its liquidity so that it would not be forced to sell assets unexpectedly or over a time period when it could not achieve an appropriate value.
Ultimately, it will be for the manager to demonstrate to the FCA during the LTAF application for authorisation process that its suggested liquidity management tools are appropriate for the investment strategy of the LTAF.
What additional governance and disclosure rules apply?
The FCA has set additional oversight and governance requirements for the LTAF, considering the risks which the LTAFs might be exposed to.
- Full scope AIFM with sufficient knowledge, skills and experience
Only a full scope alternative investment fund manager can be the manager of an LTAF.
The manager must possess the knowledge, skills and experience to understand the LTAF and risks involved in those activities and assets which the LTAF will hold. The manager must also employ sufficient personnel with relevant skills, knowledge and experience.
Where the manager delegates portfolio management, the manager cannot rely on the delegate to meet this requirement. The manager will need to provide evidence in support of its credentials at the LTAF FCA authorisation stage, and should expect a level of scrutiny in line with complexity of the asset class of the LTAF.
- Clear disclosures
In addition to strong governance, clear disclosure is a key aspect of the LTAF regime. Chapter 15 sets out the disclosure requirements for the LTAF in addition to the pre-disclosure rules set out in FUND 3.2.
Specifically, certain prospectus disclosures must be set out fairly, clearly, and in plain language. The FCA notes that the LTAF may have complex features, for example, in relation to investment strategies, subscription and redemption terms and charging structures. Clear disclosures are considered important to give investors’ confidence that they can understand the nature of the investment and make an informed decision.
Clear fees and charges disclosures are required in alignment with the rules for UCITS/NURS.
The prospectus will need to include disclosures on the due diligence process as well as dealing and redemption, including liquidity management terms, together with worked examples to explain the effects or consequences of these features. It will be important that any key information document (relevant where retail investors can invest) contains details of the main dealing features for the LTAF, as well as the fund’s aims and key risks.
- External valuer the default position
The manager will be required to appoint an “external valuer”, unless it can demonstrate that it has the competence and experience to value the types of assets in which the LTAF invests.
Where the manager acts as the valuer, it will be required to value the LTAF’s assets in line with good industry practice. The depositary will be required to determine that the manager has the resources and procedures for carrying out a valuation of the assets. This reflects the requirements in FUND 3.11.25R(2) and FUND 3.9.
Valuations must be carried out monthly.
- Due diligence
The LTAF rules follow AIFMD requirements in relation to due diligence, requiring the manager to use good market practice when undertaking due diligence, to have effective arrangements in this regard, and for these to be disclosed.
- Assessment of value and other aspects
The annual assessment of value requirement will apply to the manager of the LTAF involving the consideration of the matters set out in COLL 6.6.21R.
As the LTAF is an AIF, the manager will need to annually assess how it has managed the LTAF in the best interests of the LTAF, its investors, and the integrity of the market, pursuant to COBS 2.1.4. For the LTAF, when carrying out this assessment, the manager must consider as a minimum how the assets have been valued, how the due diligence process has been conducted, and how the manager has managed liquidity and conflicts of interest. The results of this assessment are to be included in the annual report of the LTAF.
- Quarterly reporting
The FCA rules require additional quarterly reports for investors, in addition to half-yearly and annual reports.
The FCA noted in PS21/14 that if managers wish to have additional governance features, such as advisory boards, this is permitted but it is not mandatory and needs to be considered in light of investors’ needs and the costs of such features.
- Alignment with certain other retail fund rules
As part of CP22/14, the FCA is also proposing a number of other changes to the rules which impact the LTAF, in order to align them with rules which apply to other retail authorised funds. These proposals include applying the rules on fund changes, unitholder registration, conduct of unitholder meetings, fees, and fund suspension to the LTAF in line with other retail funds. In addition, funds of alternative investment funds (FAIFs) will be able to invest up to 35 per cent of its value in units of a single LTAF. It was originally proposed that a FAIF would only be permitted to invest up to a maximum of 50 per cent of its value into LTAFs, but further to consultation feedback this requirement has now been removed, as long as the FAIF operates limited redemption arrangements to manage the liquidity mismatch. The enhanced due diligence requirements will not apply where the FAIF invests in an LTAF.
Who can the LTAF be distributed to?
The original distribution market for the LTAF, as set out in the previous rules, was limited to professional investors (including DC pension schemes), certified and self-certified sophisticated investors and certified high net worth individuals (HNWIs). The limited distribution was achieved by including units in an LTAF in the definition of NMPIs.
In CP22/14, the FCA signalled a significant relaxation of its original position, noting that it considers it appropriate to offer retail investors the choice to invest in the highly regulated and authorised LTAFs in a controlled way. Distribution of the LTAF is therefore permitted under the new COBS 4.12A (promotion of restricted mass market investments) rules to a wider market.
Under the new rules for RMMIs as regards retail investors:
- Retail investors who receive advice would be able to access the LTAF, subject to the new risk warning and risk summary being provided and of course the suitability test being met.
- In respect of direct offer financial promotions, retail investors (who are not otherwise certified, self-certified sophisticated or certified HNWIs) will be able to invest up to 10 per cent of their investable assets into an LTAF or other RMMI products (in total) (referred to as restricted investors). Firms will need to take reasonable steps to establish that a retail client is certified as a restricted investor. The new forms of certification, including for restricted investors, are contained in COBS 4 Annex 5R. In addition, the appropriateness test must be met.
As the LTAF has strong governance, oversight, and controls as an authorised fund, the FCA does not propose to require the same 24-hour cooling off period applied to other RMMIs.
The FCA noted in PS22/14 that its behavioural studies have shown that short, sharp and plain language is much more effective to help customers understand investments, in comparison to old style, long form risk warnings. The new financial promotion rules and guidance contained in PS22/10 will apply to the marketing of the LTAF, as a RMMI.
Firms will be required to provide specified risk warnings such as:
This is a high risk investment, and assets may take a long time to buy and sell. Only invest if you can wait (possibly several years) to get your money back. You do not have protection against poor performance.
Slightly different wording can be used depending on the medium of communication and any third-party restrictions on the number of characters permitted.
A specific risk summary template has also been proposed for use with the LTAF.
Does the LTAF have special tax treatment?
Certain authorised funds are required to meet the genuine diversity of ownership (GDO) condition to access the beneficial tax treatment applicable to authorised funds. This is also the case for the LTAF, however, additional provisions have been included.
Pursuant to these additional provisions, the LTAF will be treated as meeting the GDO condition where at least 70 per cent of the units or shares in the LTAF are held by one or more “relevant investors”, or by the manager of the fund in their capacity as manager.
Broadly, “relevant investors” are defined as:
An authorised unit trust scheme (or overseas equivalent) which meets the GDO condition.
An open-ended investment company (or overseas equivalent) which meets the GDO condition.
A UK or foreign regulated insurer which is not a close company.
A sovereign wealth fund.
The trustee, manager or administrator of a pension scheme, including a local government pension scheme (other than an "investment regulated pension scheme").
An “investment regulated pension scheme” is in summary, a SIPP or SSAS scheme. This means that although such schemes can invest in an LTAF, unless other investors qualify for the 70 per cent provision, the standard GDO condition needs to be satisfied.
It is also possible to apply in writing for a clearance from HMRC that a fund, including the LTAF, meets or is treated as meeting the GDO.
For SIPPs, the current position is that the LTAF would be considered a non-standard product and, where held, requires the SIPP provider to hold additional capital to provide additional client protection.
Are they any outstanding issues?
The FCA acknowledged in PS21/14 and again in PS 23/7 that the requirements applicable to authorised funds for the depositary to register the title to assets in its own name, rather than the name of the fund or the manager, is not practical for all eligible assets that an LTAF might invest in. The FCA indicated that it would consult on amending this requirement for the LTAF, but also for other categories of funds, not just the LTAF. This may well be helpful for managers interested in launching QIS funds. In the meantime, the FCA has suggested that where a firm wishes to launch an LTAF, the FCA will consider applications to waive the registration requirement in accordance with the relevant statutory tests.
The broadening of retail access is a welcome development, but there are still controls which will need to be followed if the LTAF is to be promoted to retail investors other than sophisticated or certified HNWIs.
Linked to retail access is the question of ISA eligibility. Currently, LTAFs are not qualifying investments for a stocks and shares ISA due to the 90-day notice period. However, ISA eligibility is also likely to facilitate widening access to the LTAF. The FCA has passed on feedback regarding ISA eligibility to HM Treasury and HMRC.
Tax, as ever, is an important issue. An ACS structure for the LTAF could be attractive for tax exempt investors. The PAIF regime will also be available, as we believe would be the TEF regime, but these regimes are operationally quite complex. The FCA noted in PS21/14 that it has been working closely with the Treasury and HMRC throughout the development of the LTAF, and that the Government will ensure that pre-existing tax legislation in relation to PAIFs and ACS continues to operate effectively for these regimes.
A new authorised fund type with appropriate features and safeguards for investment in long-term illiquid assets is a welcome development.
The LTAF should appeal to investors looking for exposure to Illiquid assets with a long-term horizon and appropriate risk appetite, who also want the additional oversight and governance of an FCA authorised fund. The LTAF is therefore likely to be of interest to DC pension schemes, but also potentially to larger charities and not-for-profit organisations who often have a longer-term investment horizon. There is also the possibility, expressly permitted in the rules, to have an LTAF Charity Authorised Investment Fund (CAIF). With the benefit of the favourable tax treatment of the CAIF, and the ability to hold over income from one accounting period to another, this structure could be very interesting. See our earlier briefing on CAIFs here.
A number of LTAFs have been authorised to date. The finalised rules should provide a boost to the LTAF particularly for firms who market to mass affluent and high net worth investors but for whom the NMPI regime poses too high a hurdle from a risk and target market perspective.
As with any new type of FCA authorised fund, the first LTAFs to be approved, whilst having first mover advantage, will also be the testing ground for this new type of fund. The IA is forming an implementation forum for managers, service providers and advisers who are interested in launching an LTAF.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, August 2023